Unless confidence in the euro area is restored, fragmentation forces are likely to intensify bank deleveraging, restrict lending, add to the economic woes of the periphery, and spill over to the core

The International Monetary Fund said European banks may need to sell as much as US$4.5 trillion in assets through 2013 if policy makers fall short of pledges to stem the fiscal crisis, up 18% from its April estimate.

Failure to implement fiscal tightening or set up a single supervisory system in the timing agreed could force 58 European Union banks from UniCredit SpA to Deutsche Bank AG to shrink assets, the IMF said. That would hurt credit and crimp growth by 4 percentage points next year in Greece, Cyprus, Ireland, Italy, Portugal and Spain, Europe’s periphery.

“Intensification of the crisis has manifested itself in capital outflows from the periphery to the core at a pace typically associated with currency crises or sudden stops,” the IMF wrote in its Global Financial Stability Report released this week. “Restoring confidence among private investors is paramount for the stabilization of the euro area.”

The Washington-based IMF cut its global growth forecasts Tuesday and warned of even slower expansion if European officials don’t address threats to their economies. While the European Central Bank’s plan to purchase bonds of debt-burdened countries bought governments time to act, divisions over a banking union and Spain’s reluctance to ask for a bailout threaten to boost borrowing costs.

The European rescue mechanism and the ECB bond program “must be regarded by markets as real, not ‘virtual’ and should be coupled with credible conditionality,” Jose Vinals, the director of the IMF’s monetary and capital markets department, said in prepared remarks for a press conference in Tokyo today.

Stocks Fall

Asian stocks fell for a third day today on global growth concerns, with the MSCI Asia Pacific Index down 0.8% at 12:11 p.m. in Tokyo, led by Japanese shares.

In April, the IMF forecast asset sales of US$3.8 trillion in a “weak policies scenario.” Since then, policy makers’ delay in taking decisions to solve the crisis worsened funding pressures while the relief provided by the ECB’s program of unlimited three-year loans faded.

Under a baseline scenario that has governments follow up on their commitments, the IMF sees a reduction in bank assets of US$2.8 trillion, compared with US$2.6 trillion in April.

The IMF said that “both Spain and Italy have suffered large-scale capital outflows” in the 12 months through June, with US$296 billion and US$235 billion, respectively.

“Unless confidence in the euro area is restored, fragmentation forces are likely to intensify bank deleveraging, restrict lending, add to the economic woes of the periphery, and spill over to the core,” the IMF said.

Capital Buffers

So far, the IMF estimates that deleveraging among sample banks has reached more than US$600 billion in the year through in June. Efforts to raise capital cushions have helped strengthen balance sheets and prevent larger asset sales, it said.

Looking at other countries, the report stressed that the U.S. and Japan also face risks to financial stability.

“The present difficulties in the euro area provide a cautionary tale for Japan, given the latter’s high public debt load and interdependence between banks and the sovereign that is expected to deepen over the medium term,” the IMF said.

While emerging markets have managed to weather global shocks so far, the IMF said many countries in central and eastern Europe are vulnerable to the European turmoil, while Asia and Latin America seem more resilient.

Korea, Australia

In Asian economic releases today, South Korea said its workforce expanded last month, with the unemployment rate unchanged from August at 3.1%. A report on Australian consumer confidence for October showed sentiment climbed, while New Zealand said its budget deficit was wider than earlier forecast in the fiscal year ended June 30. Philippine exports unexpectedly declined in August as electronics sales slumped, its National Statistics Office said.

France, Italy and Greece are among European nations releasing industrial production data for August today. In the U.S., the Commerce Department may say inventories rose at a slower pace in August, a Bloomberg survey showed. The Federal Reserve will release its Beige Book business survey and the Mortgage Bankers Association will report data for loan applications.